India's Financial System

Abstract
With recent growth rates among large countries second only to Chinas, India has
experienced nothing short of an economic transformation since the liberalization
process
began in the early 1990s In the last few years, with a soaring stoc! mar!et,
significant
foreign portfolio inflows including the largest pri"ate e#uity inflows in $sia, and a
rapidly de"eloping deri"ati"es mar!et, the Indian financial system has been
witnessing an
exciting era of transformation %he ban!ing sector has seen ma&or changes with
deregulation of interest rates and the emergence of strong domestic pri"ate players
as
well as foreign ban!s $t the same time, there is some e"idence of credit
constraints for
Indias '() firms that rely hea"ily on trade credit Corporate go"ernance norms in
India
ha"e strengthened rapidly in the past few years *amily businesses, howe"er, still
dominate the landscape and in"estor protection, while excellent on paper, appears
to be
less effecti"e owing to an o"erburdened legal system and corruption In the last
few years
microfinance has contributed in a big way to financial inclusion and is now
attracting
"enture capital and for+profit companies , both domestic and foreign









India's Financial System
Overview
-ne of the ma&or economic de"elopments of this decade has been the recent ta!e+
off of India, with growth rates a"eraging in excess of ./ for the last four years, a
stoc!
mar!et that has risen o"er three+fold in as many years with a rising inflow of
foreign
in"estment In 0001, total e#uity issuance reached 2190bn in India, up 00 per cent
(erger and ac#uisition "olume was a record 203.bn, up 4. per cent, dri"en by a
431 per
cent increase in outbound ac#uisitions exceeding for the first time inbound deal
"olumes
5ebt issuance reached an all+time high of 2143bn, up 0. per cent from a year
earlier
Indian companies were also among the world6s most acti"e issuers of depositary
receipts
in the first half of 0001, accounting for one in three new issues globally, according
to the
7an! of 8ew 9or!
%he #uestions and challenges that India faces in the first decade of the new
millennium are therefore fundamentally different from those that it has wrestled
with for
decades after independence :iberalization and globalization ha"e breathed new
life into
the foreign exchange mar!ets while simultaneously besetting them with new
challenges
Commodity trading, particularly trade in commodity futures, ha"e practically
started
from scratch to attain scale and attention %he ban!ing industry has mo"ed from an
era of
rigid controls and go"ernment interference to a more mar!et+go"erned system
8ew
pri"ate ban!s ha"e made their presence felt in a "ery strong way and se"eral
foreign
ban!s ha"e entered the country -"er the years, microfinance has emerged as an
important element of the Indian financial system increasing its outreach and
pro"iding
much+needed financial ser"ices to millions of poor Indian households
Financial System;
%he word ;system;, in the term ;financial system;, implies a set of complex and
closely connected or interlined institutions, agents, practices, mar!ets, transactions,
claims, and liabilities in the economy %he financial system is concerned about
money, credit and finance+the three terms are intimately related yet are somewhat
different from each other Indian financial system consists of financial mar!et,
financial instruments and financial intermediation
Role/ Functions of Financial System:
$ financial system performs the following functions<
= It ser"es as a lin! between sa"ers and in"estors It helps in utilizing the mobilized
sa"ings of scattered sa"ers in more efficient and effecti"e manner It channelises
flow of sa"ing into producti"e in"estment
= It assists in the selection of the pro&ects to be financed and also re"iews the
performance of such pro&ects periodically
= It pro"ides payment mechanism for exchange of goods and ser"ices
= It pro"ides a mechanism for the transfer of resources across geographic
boundaries
= It pro"ides a mechanism for managing and controlling the ris! in"ol"ed in
mobilizing sa"ings and allocating credit
= It promotes the process of capital formation by bringing together the supply of
sa"ing and the demand for in"estible funds
= It helps in lowering the cost of transaction and increase returns >educe cost
moti"es people to sa"e more
= It pro"ides you detailed information to the operators? players in the mar!et such
as indi"iduals, business houses, @o"ernments etc
Components/ Constituents of Indian Financial system<
%he following are the four main components of Indian *inancial system
1 *inancial institutions
0 *inancial (ar!ets
4 *inancial Instruments?$ssets?'ecurities
A *inancial 'er"ices
Financial institutions: *inancial institutions are the intermediaries who facilitates
smooth functioning of the financial system by ma!ing in"estors and borrowers
meet %hey mobilize sa"ings of the surplus units and allocate them in producti"e
acti"ities promising a better rate of return *inancial institutions also pro"ide
ser"ices to entities see!ing ad"ises on "arious issues ranging from restructuring to
di"ersification plans %hey pro"ide whole range of ser"ices to the entities who
want to raise funds from the mar!ets elsewhere *inancial institutions act
as financial intermediaries because they act as middlemen between sa"ers and
borrowers Were these financial institutions may be of 7an!ing or 8on+7an!ing
institutions
Financial ar!ets:
*inance is a prere#uisite for modern business and financial institutions play a "ital
role in economic system It6s through financial mar!ets the financial system of an
economy wor!s %he main functions of financial mar!ets are<
1 to facilitate creation and allocation of credit and li#uidityB
0 to ser"e as intermediaries for mobilization of sa"ingsB
4 to assist process of balanced economic growthB
A to pro"ide financial con"enience
Financial Instruments
$nother important constituent of financial system is financial instruments %hey
represent a claim against the future income and wealth of others It will be a claim
against a person or an institutions, for the payment of the some of the money at a
specified future date
Financial Services:
)fficiency of emerging financial system largely depends upon the #uality and
"ariety of financial ser"ices pro"ided by financial intermediaries %he term
financial ser"ices can be defined as ;acti"ites, benefits and satisfaction connected
with sale of money, that offers to users and customers, financial related "alue;
"#e Indian $conomy %% A &rief 'istory
%he second most populated country in the world C111 billionD, India currently has
the fourth largest economy in EEE terms, and is closing in at the heels of the third
largest
economy, Fapan C%able 11D $t independence from the 7ritish in 19A3, India
inherited
one of the worlds poorest economies Cthe manufacturing sector accounted for only
one 0
tenth of the national productD, but also one with arguably the best formal financial
mar!ets in the de"eloping world, with four functioning stoc! exchanges Cthe
oldest one
predating the %o!yo 'toc! )xchangeD and clearly defined rules go"erning listing,
trading
and settlementsB a well+de"eloped e#uity culture if only among the urban richB a
ban!ing
system with clear lending norms and reco"ery proceduresB and better corporate
laws than
most other erstwhile colonies %he 19G1 Indian Companies $ct, as well as other
corporate laws and laws protecting the in"estors rights, were built on this
foundation
$fter independence, a decades+long turn towards socialism put in place a regime
and culture of licensing, protection and widespread red+tape breeding corruption
In
1990+91 India faced a se"ere balance of payments crisis ushering in an era of
reforms
comprising deregulation, liberalization of the external sector and partial
pri"atization of
some of the state sector enterprises *or about three decades after independence,
India
grew at an a"erage rate of 4G/ Cinfamously labeled Hthe Iindu rate of growthJD
and then
accelerated to an a"erage of about G1/ since the 19.0s %he growth surge
actually
started in the mid+1930s except for a disastrous single year, 1939+.0 $s we ha"e
seen in
%able 11, the annual @5E growth rate Cbased on inflation ad&usted, constant
pricesD of
G9/ during 1990+000G is the second highest among the worlds largest
economies,
behind only Chinas 101/
In 000A, G0/ of Indias @5E was generated in the ser"ices sector, while
manufacturing CagricultureD produced 01/ C00/D of @5E In terms of
employment,
howe"er, agriculture still accounts for about two+thirds of the half a billion labor
force,
indicating both poor producti"ity and widespread underemployment -"er 90/ of
the
labor force wor!s in the Hunorganized sectorJ
Indian $conomy and Financial ar!ets since liberali(ation
"#e )omestic $conomy
%here is hardly a facet of economic life in India that has not been radically altered
since the launch of economic reforms in the early 90s %he twin forces of
globalization
$ccording to the official definition, the unorganized sector is comprised of<
1D all the enterprises except units registered under 'ection 0mCiD and 0mCiiD of the
*actories $ct, 19A., and 7idi and Cigar Wor!ers Ccondition of employmentD $ct,
1911B and
0D all enterprises except those run by the go"ernment Ccentral, state and local
bodiesD or Eublic 'ector )nterprises and the deregulation ha"e breathed a new life
to pri"ate business and the long+protected industries in India are now faced with
both the challenge of foreign competition as well as the opportunities of world
mar!ets %he growth rate has continued the higher tra&ectory started in 19.0 and
the @5E has nearly doubled in constant prices Csee figure 11D
%he end of the H:icence >a&J has remo"ed ma&or obstacles from the path of new
in"estment and capacity creation %he effect is clearly "isible in figure 10 that
shows the
ratio of capital formation in the pri"ate sector to that in the public sector for a
decade
preceding liberalization and for the period following it %he unmista!able ascent in
the
ratio following liberalization points to the unshac!led pri"ate sectors march
towards
attaining the Hcommanding heightsJ of the economy In terms of price stability, the
a"erage rate of inflation since liberalization has stayed close to the preceding half
decade
except in the last few years when inflation has declined to significantly lower
le"els Csee
figure 14D
Eerhaps the biggest structural change in Indias macro+economy, apart from the
rise in the growth rate, is the steep decline in the interest rates $s figure 1A shows,
interest rates ha"e fallen to almost half in the period following the reforms,
bringing
down the corporate cost of capital significantly and increasing the competiti"eness
of
Indian companies in the global mar!etplace
"#e $*ternal Sector and t#e Outside +orld
$long with deregulation, globalization has played a !ey role in transforming the
Indian economy in the past dozen years $ #uic! measure of the rise in Indias
integration
with the world economy is a standard gauge of HopennessJ , the importance of
foreign
trade in the national income *igure 1G shows the unmista!able rise in the share of
imports and exports in Indias @5E since 1990+91 In &ust o"er a decade since
liberalization, the share of foreign trade in Indias @5E had increased by o"er
G0/
While imports increased steadily and continued to exceed exports, the rise in the
latter
has been almost proportional as well %he Hexport pessimismJ that mar!ed Indias
foreign trade policy truly appears to be a thing of the past
While trade deficits ha"e continued after liberalization, foreign in"estment in
India, both
portfolio flows as well as *5I, Cand more recently in the form of external
commercial
borrowing C)C7sD by Indian firmsD ha"e been substantial *igure 11 shows the
flow of
foreign in"estment to India and decomposes it into *5I and portfolio in"estment
7oth
!inds of flows ha"e shown remar!able growth rates with comparable a"erage
le"els o"er
the years Iowe"er the portfolio flows ha"e been much more "olatile as compared
to *5I
flows %his raises the familiar concerns o"er Hhot moneyJ flows into the country
with
portfolio flows
$s for *5I, perhaps much of the potential still lays untapped $ recent study by
(organ 'tanley holds Hbureaucracy, poor infrastructure, rigid labor laws and an
unfa"orable tax structureJ in India as responsible for this poor relati"e
performance
8e"ertheless this difference should be "iewed more as indicati"e of future growth
opportunities in *5I inflows pro"ided India properly carries out its second
generation
reforms and should not obscure Indias significant achie"ement in attracting
foreign
in"estment in the years since liberalization
$s a result of substantial capital inflows, the foreign exchange reser"es situation
for India has impro"ed beyond the wildest imagination of any pre+liberalization
policyma!er %oday the >eser"e 7an! has a foreign exchange reser"e exceeding
two
hundred billion K' dollars, a situation unthin!able at the beginning of
liberalization when
India barely had reser"es to co"er a few wee!s of imports *igure 13 shows the
e"olution
of Indias foreign exchange reser"e position since liberalization
%he Indian rupee has largely stabilized against ma&or world currencies, o"er the
period %he economic reforms era began with a sharp de"aluation of the rupee $s
liberalization lifted controls on the rupee in the trade account, there were
considerable
concerns about its "alue Iowe"er, propped up largely by inflows of foreign
in"estment
the floating rupee stabilized in the late 90s and has appreciated somewhat against
the K'
dollar in recent months In fact, it is fair to say that the rupee is currently
considerably
under"alued against the dollar as its "alue is managed by the >7I *igure 1.
shows the
"ariation in the external "alue of the rupee in the post+reforms period
$ lot has changed in the world beyond Indias borders during these years Fapan,
the second largest economy in the world, has experienced a deep and long
recession o"er
much of the period %he $sian Crisis, one of the most widespread of all financial
and
currency crises e"er, de"astated 'outh+)ast $sia and Lorea in 1993 Continental
)urope
has entered into a monetary union creating the )uro that now ri"als the K' dollar
in
importance as a world currency 'e"eral economies li!e >ussia, $rgentina and
%ur!ey
ha"e witnessed financial crises %he internet bubble too! stoc! mar!ets in the K'
and
se"eral other countries to dizzying heights before crashing bac! down (ore
recently, K'
sub+prime mar!et woes ha"e spar!ed global sell+offs
India has appeared largely unscathed from the $sian crisis (ost obser"ers
attribute this insulation to the capital controls that continue in India 8e"ertheless,
Indian
financial mar!ets ha"e progressi"ely become more attuned to international mar!et
forces
%he reaction of Indian mar!ets to the recent sub+prime meltdown bears testimony
to the
le"el of financial integration between India and the rest of the world
"#e Financial Sector
$long with the rest of the economy and perhaps e"en more than the rest, financial
mar!ets in India ha"e witnessed a fundamental transformation in the years since
liberalization %he going has not been smooth all along but the o"erall effects ha"e
been
largely positi"e
-"er the decades, Indias ban!ing sector has grown steadily in size Cin terms of
total depositsD at an a"erage annual growth rate of 1./ %here are about 100
commercial
ban!s in operation with 40 of them state owned, 40 pri"ate sector ban!s and the
rest A0
foreign ban!s 'till dominated by state+owned ban!s Cthey account for o"er .0/
of
deposits and assetsD, the years since liberalization ha"e seen the emergence of new
pri"ate sector ban!s as well as the entry of se"eral new foreign ban!s %his has
resulted
in a much lower concentration ratio in India than in other emerging economies
C5emirgMN+Lunt and :e"ine 0001D Competition has clearly increased with the
Ierfindahl index Ca measure of concentrationD for ad"ances and assets dropping by
o"er
0./ and about 00/ respecti"ely between 1991+1990 and 0000+0001 CLoe"a
0004D
Within a decade of its formation, a pri"ate ban!, the ICICI 7an! has become the
second
*ollowing ::'O, the score on the horizontal axis is the sum of Co"erallD creditor
rights, shareholder rights, rule of law, and go"ernment corruption %he score of the
"ertical axis indicates the distance of a countrys o"erall external mar!ets score
Cexternal cap?@8E, domestic firms?Eop, IE-s?Eop, 5ebt?@8E, and :og @8ED to
the mean of all countries, with a positi"e Cnegati"eD figure indicating that this
countrys o"erall score is higher ClowerD than the mean largest in India
Compared to most $sian countries the Indian ban!ing system has done better in
managing its 8E: problem %he HhealthyJ status of the Indian ban!ing system is
in part due to its high standards in selecting borrowers Cin fact, many firms
complained about the
stringent standards and lac! of sufficient fundingD, though there is some concern
about He"er+greeningJ of loans to a"oid being categorized as 8E:s In terms of
profitability, Indian ban!s ha"e also performed well compared to the ban!ing
sector in other $sian economies, as the returns to ban! assets and e#uity in %able
11 con"ey Eri"ate ban!s are today increasingly displacing nationalized ban!s
from their
positions of pre+eminence %hough the nationalized 'tate 7an! of India C'7ID
remains the
largest ban! in the country by far, new pri"ate ban!s li!e ICICI 7an!, K%I 7an!
Crecently renamed $xis 7an!D and I5*C 7an! ha"e emerged as important players
in the
retail ban!ing sector %hough spawned by go"ernment+bac!ed financial institutions
in
each case, they are profit+dri"en professional enterprises
%he proportion of non+performing assets C8E$sD in the loan portfolios of the
ban!s is one of the best indicators of the health of the ban!ing sector, which, in
turn, is
central to the economic health of the nation *igure 111 shows the distribution of
8E$s
in the different segments of the Indian ban!ing sector for the last few years
Clearly the
foreign ban!s ha"e the healthiest portfolios and the nationalized ban!s the worst,
but the
downward trend across the board is indeed a positi"e feature $lso, while there is
still
room for impro"ement, the o"erall ratios are far from alarming particularly when
compared to some other $sian countries
While the ban!ing sector has undergone se"eral changes, e#uity mar!ets ha"e
experienced tumultuous times as well %here is no doubt that the post+reforms era
has
witnessed considerably higher a"erage stoc! mar!et returns in general as
compared to
before *igure 110 clearly shows the ta!e+off in 7') 8ational Index and 7')
(ar!et
Capitalization beginning with the reforms
'ince the beginning of the reforms, He#uity cultureJ has spread across the country
to an extent more than e"er before %his trend is clearly "isible in figure 114
which
shows the ratio of 7') mar!et capitalization to the @5E $lthough @5E itself has
risen
faster than before, the long+term growth in e#uity mar!ets has been significantly
higher 10
%he rise in stoc! prices Cand the associated drop in cost of e#uityD has been
accompanied by a boom in the amounts raised through new issues , both stoc!s as
well
as debentures , beginning with the reforms and continuing at a high le"el for o"er
half a
decade Cfigure 11AD
%he ride has not been smooth all along though $t least two ma&or bubbles ha"e
roc!ed the Indian stoc! mar!ets since liberalization %he first, coinciding with the
initial
reforms, raised #uestions about the reliability of the e#uity mar!et institutions $
&oint
parliamentary committee in"estigation and ma&or media attention notwithstanding
another crisis hit the bourses in 199. and yet again in 0001 Clearly se"eral
institutional
problems ha"e played an important role in these recurring crises and they are being
fixed
in a reacti"e rather than pro+acti"e manner $ppropriate monitoring of the bourses
remains a thorny issue and foul play, a feature that is far from absent e"en in
de"eloped
countries, is, unfortunately, still common in India Conse#uently, e"ery steep rise in
stoc!
"alues today instills foreboding in some minds about a possible re"ersal
8e"ertheless,
institutions ha"e doubtless impro"ed and become more transparent o"er the period
%he
time+honored HbadlaJ system of rolling settlements is now gone and deri"ati"es
ha"e
firmly established themsel"es on the Indian scene
Indeed the introduction and rapid growth of e#uity deri"ati"es ha"e been one of
the defining changes in the Indian financial sector since liberalization
8otwithstanding
considerable resistance from traditional bro!ers in Indian exchanges, futures and
options
trading began in India at the turn of the century *igure 11G shows the rapid
growth in
the turno"er in the 8') deri"ati"es mar!et bro!en down into different instrument+
types
)"idently futures , both on indi"idual stoc!s as well as index futures , ha"e been
more
popular than options, but the o"erall growth in less than half a decade has been
phenomenal indeed %radable interest rate futures ha"e made their appearance as
well but
their trading "olume has been negligible and sporadic 8e"ertheless, the fixed+
income
deri"ati"es section has witnessed considerable growth as well with Interest >ate
'waps
and *orward >ate $greements being fre#uently used in inter+ban! transactions as
well as
for hedging of corporate ris!s 'imilarly currency swaps, forward contracts and
currency
options are being increasingly used by Indian companies to hedge currency ris!
11
*inally the mar!et for corporate control has seen a surge of acti"ity in India in
recent years *igures 111 shows the e"olution of mergers and ac#uisitions
in"ol"ing
Indian firms while table 13 lists the industries with maximum action *oreign
pri"ate
e#uity has been a ma&or player in this area with inflows of o"er 200 billion in
0001, the
largest in any $sian country
%he next section ma!es an assessment of the legal and institutional aspects of
in"estor protection in India 'ection 4 pro"ides the details of performance of
capital
mar!ets in India 'ection A pro"ides the trends of *II flows in India 'ection G
loo!s at
the performance aggregates of the ban!ing sector 'ection 1 pro"ides corporate
go"ernance issues and recent findings %he last section highlights future research
issues
Stoc! $*c#an,es in India
India currently has two ma&or stoc! exchanges< the 8ational 'toc! )xchange
C8')D established in 199A and the 7ombay 'toc! )xchange C7')D, the oldest
stoc!
exchange in $sia, established in 1.3G Kp to 1990, 7') was a monopoly, mar!ed
with
inefficiencies, high costs of intermediation, and manipulati"e practices, so that
external
mar!et users often found themsel"es disad"antaged %he economics reforms
created four
new institutions< the 'ecurities and )xchanges 7oard of India C')7ID, the 8ational
'toc!
)xchange C8')D, the 8ational 'ecurities Clearing Corporation C8'CCD, and the
8ational
'ecurities 5epository C8'5:D %he 8ational 'toc! )xchange C8')D, a limited
liability 1.
company owned by public sector financial institutions, now accounts for about
two+thirds
of the stoc! exchange trading in India, and "irtually all of its deri"ati"es trading
%he 8ational 'ecurities Clearing Corporation C8'CCD is the legal counter+party to
net obligations of each bro!erage firm, and thereby eliminates counter+party ris!
and
possibility of payments crises It follows a rigorous Pris! containment framewor!
in"ol"ing collateral and intra,day monitoring %he 8'CC, duly assisted by the
8ational
'ecurities 5epository C8'5:D, has an excellent record of reliable settlement
schedules
since its inception in the mid+nineties
%he 'ecurities and )xchanges 7oard of India C')7ID has introduced a rigorous
regulatory regime to ensure fairness, transparency and good practice *or example,
for
greater transparency, ')7I has mandated mandatory disclosure for all transactions
where
total #uantity of shares is more than 0G/ of the e#uity of the company 7ro!ers
disclose
to the stoc! exchange, immediately after trade execution, the name of the client in
addition to trade detailsB and the 'toc! exchange disseminates the information to
the
general public on the same day
%he new en"ironment of transparency, fairness and efficient regulation led 7'),
in 1991, to also become a transparent electronic limit order boo! mar!et with an
efficient
trading system similar to the 8') )#uity and e#uity deri"ati"es trading in India
has s!y+
roc!eted to record le"els o"er the course of the last ten years
In 000G, about G000 companies were listed and traded on 8') and?or 7') While
the dollar "alue of trading on the Indian stoc! exchanges is much lower than the
dollar
"alue of trading in )urope or in the K', it is important to note that the number of
e#uity
trades on 7')?8') is ten times greater than that of )uronext or :ondon, and of the
same
order of magnitude as that of 8$'5$Q?89') 'imilarly, the number of
deri"ati"es
trades on 8') is se"eral times greater than that of )uronext? :ondon, and of an
order of
magnitude comparable to K' deri"ati"es exchanges %he number of trades is an
important indicator of the extent of in"estor interest and in"estor participation in
e#uities
and e#uity trading, and emphasizes the crucial importance of corporate go"ernance
practices in India
Institutional Features
%he transactions in secondary mar!ets li!e 8') and 7') go through clearing at
clearing corporations C8ational 'ecurities Clearing Corporation :imited C8'CC:D
for
8') trades, for instanceD where determination of funds and securities obligations
of the
trading members and settlement of the latter ta!e place $ll the securities are being
traded
and settled under %R0 rolling settlement H5ematerializedJ, trading of securities,
ie
paper+less trading using electronic accounts, now accounts for "irtually all e#uity
transactions %his was introduced to reduce the menace of fa!e and stolen
securities and 0A
to enhance the settlement efficiency, with the first depository C8ational 'ecurity
5epository :imited established for 8') in 1991 %his ushered the era of
paperless
trading and settlement %able 49 shows the progress of dematerialization at 8'5:
and
the Central 5epository 'er"ices CIndiaD :imited CC5':D %able 410 pro"ides the
deli"ery pattern of "arious stoc! exchanges in India $s a measure of in"estor
protection,
exchanges in India Cboth the 8') and 7')D administer price bands and also
maintain strict
sur"eillance o"er mar!et acti"ities in illi#uid and "olatile stoc!s 7esides, 8'CC:
has put in place
an on+line monitoring and sur"eillance system and monitors members on a real
time basis In
addition, there is regulatory re#uirement by ')7I that 00/ of the acti"e trading
members being
inspected e"ery year to "erify their le"el of compliance with "arious rules
)ebt ar!et
%he debt mar!et in India has remained predominantly a wholesale mar!et 5uring
000G+0001, the go"ernment and corporate sector collecti"ely has mobilized >s 01
trillion
from the primary debt mar!et -f which, 191/ were raised by go"ernment and
the
balance by the corporate sector 7ut in terms of turno"er in the secondary mar!et,
go"ernment securities dominate %he secondary mar!et for corporate bonds is
practically
non+existent C>efer *igure 41D $t the end of (arch 0001, the total mar!et
capitalization
of securities a"ailable for trading at the W5( segment stood at o"er >s 1G trillion
C 2
43G billionD -f this go"ernment securities and state loans together accounted for
.4/ of
total mar!et capitalization C>efer *igure 40 and %able 411D
@o"ernment of India, public sector units and corporations together comprise as
dominant issuer of debt mar!ets in India :ocal go"ernments, mutual funds and
international financial institution issue debt instruments as well but "ery
infre#uently
%he Central @o"ernment mobilizes funds mainly through issue of dated securities
and %+
bills 7onds are also issued by go"ernment sponsored institutions li!e the
de"elopment
financial institutions C5*IsD li!e I*CI and I57I, ban!s and public sector units
'ome, but
not all, of the E'K bonds are tax+exempt %he corporate bond mar!et comprise of
commercial papers and bonds In recent years, there has been an increase in
issuance of 0G
corporate bonds with embedded put and call options %he ma&or part of debt is
pri"ately
placed with tenors of 1+10 years
@o"ernment securities include *ixed Coupon 7onds, *loating >ate 7onds, Sero
Coupon 7onds, and %+7ills %he secondary mar!et trades are negotiated between
participants with '@: C'ubsidiary @eneral :edgerD accounts with >7I %he
8egotiated
5eli"ery 'ystem C85'D of >7I pro"ides electronic platform for negotiating trades
%rades are also executed on electronic platform of the Wholesale 5ebt (ar!et
CW5(D
segment of 8') %able 410 shows the growth of W5( segment of 8') %he
a"erage
trade size in this mar!et has ho"ered around >s 30 million C2 13G millionD and
while
turno"er has risen significantly, the rise has not been uniform
Central and 'tate go"ernments together ha"e borrowed >s 1. trillion C2 AG
billionD CgrossD and repaid o"er >s 1.0 billion C2 13 billionD during 000G+01 -ut of
this
o"er >s 14 trillion C2 40G billionD was raised by central go"ernment through dated
securities -n a net basis, the go"ernment has borrowed o"er >s 9G4 billion C2
04.4
billionD through dated securities and only slightly o"er >s 0. billion C2 03 billionD
through 41A+day %+7ills %he net borrowings of 'tate go"ernments in 000G+01
amounted
to slightly o"er >s 1GA billion C2 4.G billionD
%he yield on primary issues of dated go"ernment securities during 000G+01 "aried
between 119 / and 39. / against the range of AA9/ to .0A / during 000A+0G
%he
weighted a"erage yield on go"ernment dated securities increased to 34A/ from
111/ in
000A+0G
$t about 0/ of the @5E, the corporate bond mar!et in India is small, marginal,
and heterogeneous in comparison with corporate bond mar!et in de"eloped
countries
While a corporate debt mar!et in India has existed in India since 19G0s, the bul! of
the
debt has been raised through pri"ate placements In 000A+0G, close to >s G94
billion
C2 1A4 billionD was raised by the corporate sector through debt instruments, of
which
pri"ate placements accounted for around 94 / In 000G+01, the entire amount of
o"er >s
39A billion C2 19.G billionD was raised by 99 issuers through 410 pri"ately placed
issues,
with no public issues at all *igure 44 shows the growth of pri"ate placement debt
in
India *inancial Institutions and ban!s dominate in pri"ate placements, issuing 3G
/ of
the total pri"ate placement of debt C>efer *igure 4AD $round 1.10 / of the
resources 01
mobilized by pri"ate placement were distributed to *inancial and 7an!ing sector
and
91A / to Eower sector, while distribution to %elecommunications and Water
resources
together was less than 1 / 5uring 000G+01, the maturity profile of issues in
pri"ate
placements ranged between 10 months to 0A0 months
%o promote the corporate debt mar!et, especially secondary mar!et regulators
ha"e ta!en se"eral steps Corporate 5ebt instruments are traded both on 7') and
on
capital mar!et and the W5( segments of the 8') ')7I has already mandated
that all
bonds traded on the 7') and 8') be executed on the basis of price?order
matching 'o,
the difference between trading of go"ernment securities and corporate debt mar!et
securities is that the latter are traded on the electronic limit order boo! li!e
e#uities 'ince
Fune 0000, the C5': and 8'5: ha"e admitted debt instruments such as
debentures,
bonds, CEs C5s, etc $lso, ban!s, financial institutions and primary dealers ha"e
been
as!ed to hold bonds and debentures, pri"ately placed or other wise, in electronic
form $s
on (arch 0001, o"er >s 44 trillion C2 .0G billionD worth of bonds?debentures
were
a"ailable in paperless CelectronicD form consisting of 1G0 issuers with 13,G0.
debentures?bonds and 439 issuers with 3,4G3 issues of commercial paper
In terms of mar!et participants, apart from in"estors and bro!ers, there were 13
Erimary 5ealers . at the end of (arch 0001 5uring 000G+01, ban!s CIndian and
*oreignD
accounted for A0/ of the W5( turno"er, while primary dealers accounted for
01/ of
the total turno"er C>efer *igure 4GD In recent years mutual funds ha"e emerged as
an
important in"estor class in the debt mar!et %hey also raise funds through the debt
mar!et (ost mutual funds ha"e specialized debt funds such as gilt funds and
li#uid
funds *oreign Institutional In"estors C*IIsD are also permitted to in"est in treasury
and
corporate bonds, but up to a limit Ero"ident and pension funds are large in"estors
in debt
mar!et, predominantly in treasury and E'K bonds %hey are, howe"er, not "ery
acti"e
traders owing largely to regulatory restrictions
Conclusion: %he Indian financial system has undergone structural transformation
o"er the past decade %he financial sector has ac#uired strength, efficiency and
stability by the combined effect of competition, regulatory measures, and policy
en"ironment While competition, consolidation and con"ergence ha"e been
recognized as the !ey dri"ers of the ban!ing sector in the coming years
)erivatives ar!et
A&S"RAC"
%he Indian deri"ati"e mar!et has become multi+trillion dollar mar!ets o"er the
years (ar!ed with the ability to partially and fully transfer the ris! by loc!ing in
assets prices, deri"ati"es are gaining popularity among the in"estors 'ince the
economic reforms of 1991, maximum efforts ha"e been made to boost the
in"estors confidence by ma!ing the trading process more users friendly 'till,
there are some issues in this mar!et 'o, the present paper is an attempt to study the
e"olution of Indian deri"ati"e mar!et, trading mechanism in its "arious products
and the future prospects of the Indian 5eri"ati"e mar!et %he present paper is
descripti"e in nature and based on the secondary data Inspite of the growth in the
deri"ati"e mar!et, there are many issue Ceg, the lac! of economies of scale, tax
and legal bottlenec!s, increased off+balance sheet exposure of Indian ban!s need
for an independent regulator etcD, which need to be immediately resol"ed to
enhance the in"estors confidence in the Indian deri"ati"e mar!et
I-"RO).C"IO-
*ixed exchange rate was in existence under the 7retton Woods system $ccording
to $"adhani C0000D, *inancial deri"ati"es came into the spotlight, when during the
post+ 1930 period, the K' announced its decision to gi"e up gold+ dollar parity, the
basic !ing pin of the 7retton Wood 'ystem of fixed exchange rates With the
dismantling of this system in 1931, exchange rates couldnt be !ept fixed
Interest rates became more "olatile due to high employment and inflation rates
:ess de"eloped countries li!e India opened up their economies and allowed prices
to "ary with mar!et conditions Erice fluctuations made it almost impossible for
the corporate sector to estimate future production costs and re"enues %he
deri"ati"es pro"ided an effecti"e tool to the problem of ris! and uncertainty due to
fluctuations in interest rates, exchange rates, stoc! mar!et prices and the other
underlying assets %he deri"ati"e mar!ets ha"e become an integral part of modern
financial system in less than three decades of their emergence %his paper
describes the e"olution of Indian deri"ati"es mar!et, trading mechanism in its
"arious securities, the "arious unsol"ed issues and the future prospects of the
deri"ati"es mar!et
)erivatives
'ection 0CacD of 'ecurities Contract >egulation $ct C'C>$D 19G1 defines
5eri"ati"e as< aD Ha security deri"ed from a debt instrument, share, loan whether
secured or unsecured, ris! instrument or contract for differences or any other form
of securityB bD Ha contract which deri"es its "alue from the prices, or index of
prices, of underlying securitiesJ %he International (onetary *und C0001D defines
deri"ati"es as Hfinancial instruments that are lin!ed to a specific financial
instrument or indicator or commodity and through which specific ris!s can be
traded in financial mar!ets in their own right %he "alue of a financial deri"ati"e
deri"es from the price of an underlying item, such as an asset or index Knli!e debt
securities, no principal is ad"anced to be repaid and no in"estment income
accruesJ
/articipants in t#e derivative mar!et:
Eatwari and 7harga"a C0001D stated that there are three broad categories of
participants in the deri"ati"e mar!et %hey are< Iedgers, 'peculators and
$rbitrageurs $ Iedger is a trader who enters the deri"ati"e mar!et to reduce a
pre+ existing ris! In India, most deri"ati"es users describe themsel"es as hedgers
C*itch >atings, 000AD and Indian laws generally re#uire the use of deri"ati"es for
hedging purposes only 'peculators, the next participant in the deri"ati"e mar!et,
buy and sell deri"ati"es to boo! the profit and not to reduce their ris! %hey wish to
ta!e a position in the mar!et by betting on future price mo"ement of an asset
'peculators are attracted to exchange traded deri"ati"e products because of their
high li#uidity, high le"erage, low impact cost, low transaction cost and default ris!
beha"ior *utures and options both add to the potential gain and losses of the
speculati"e "enture It is the speculators who !eep the mar!et going because they
bear the ris!s, which no one else is willing to bear
%he third participant, $rbitrageur is basically ris!+a"erse and enters into the
contracts, ha"ing the potential to earn ris!less profits It is possible for an
arbitrageur to ha"e ris!less profits by buying in one mar!et and simultaneously
selling in another, when mar!ets are imperfect Clong in one mar!et and short in
another mar!etD $rbitrageurs always loo! out for such price differences
$rbitrageurs fetch enormous li#uidity to the products which are exchanges traded
%he li#uidity in+turn results in better price disco"ery, lesser mar!et manipulation
and lesser cost of transaction
$ccording to (urti 0000, Hthe hedgers, the speculators and the arbitrageurs all
three must co+exist In simple words, all the three type of participants are re#uired
not only for the healthy functioning of the deri"ati"e mar!et, but also to increase
the li#uidity in the mar!et %he mar!et would become mere tools of gambling
without the hedgers, as they pro"ide economic substance to the mar!et
'peculators pro"ide depth and li#uidity to the mar!et $rbitrageurs help price
disco"ery and bring uniformity in prices
0iterature Review
$ccording to @reenspan C1993D H7y far the most significant e"ent in finance
during the past decades has been the extraordinary de"elopment and expansion of
financial deri"ati"esTJ $"adhani C0000D stated that a deri"ati"e, an inno"ati"e
financial instrument, emerged to protect against the ris!s generated in the past, as
the history of financial mar!ets is repleted with crisesD )"ents li!e the collapse of
the fixed exchange rate system in 1931, the 7lac! (onday of -ctober 19.3, the
steep fall in the 8i!!ei in 19.9, the K' bond debacle of 199A, occurred because of
"ery high degree of "olatility of financial mar!ets and their unpredictability 'uch
disasters ha"e become more fre#uent with increased global integration of mar!ets
'ahoo C1993D opines H5eri"ati"es products initially emerged, as hedging de"ices
against fluctuation in commodity prices and the commodity+lin!ed deri"ati"es
remained the sole form of such products for many years (arlowe C0000D argues
that the emergence of the deri"ati"e mar!et products most notably forwards,
futures and options can be traced bac! to the willingness of ris!+a"erse economic
agents to guard themsel"es against uncertainties arising out of fluctuations in asset
prices
It is generally stated that regulation has an important and critical role to ensure the
efficient and smooth functioning of the mar!ets $ccording to 'ahoo C1993D the
legal framewor! for deri"ati"es trading is a critical part of o"erall regulatory
framewor! of deri"ati"e mar!ets %he purpose of regulation is to encourage the
efficiency and competition rather than impeding it Iathaway C199.D stated that,
while there is a percei"ed similarity of regulatory ob&ecti"e, there is no single
preferred model for regulation of deri"ati"e mar!ets 5eri"ati"es include a wide
range of financial contracts, including forwards, futures, swaps and options
*orward contract is an agreement between two parties calling for deli"ery of, and
payment for, a specified #uantity and #uality of a commodity at a specified future
date %he price may be agreed upon in ad"ance, or determined by formula at the
time of deli"ery or other point in timeJ CWeb 0D Fust li!e other instruments, it is
used to control and hedge currency exposure ris! Ceg forward contracts on K'5
or )K>D or commodity prices Ceg forward contracts on oilD Eatwari and
7harga"a C0001D explain it in simple words and further add that one of the parties
to a forward contract assumes a long position and agrees to buy the underlying
asset at a certain future date for a certain price and the other agrees to short it %he
specified price is referred to as the deli"ery price %he parties to the contract
mutually agree upon the contract terms li!e deli"ery price and #uantity
WebA states that H$ *utures Contract is a standardized contract, traded on a
futures exchange, to buy or sell a certain underlying instrument at a certain date in
the future, at a pre+set price %he future date is called the deli"ery date or final
settlement date %he pre+set price is called the futures price %he price of the
underlying asset on the deli"ery date is called the settlement price %he futures
price, naturally, con"erges towards the settlement price on the deli"ery dateJ
'irisha C0001D explain the %ypes of *utures which are as follows<
*oreign )xchange *utures
Currency *utures
'toc! Index *utures
Commodity *utures
Interest >ate *utures
Web G defines H$n -ptions Contract is the right, but not the obligation, to buy Cfor
a call optionD or sell Cfor a put optionD a specific amount of a gi"en stoc!,
commodity, currency, index, or debt, at a specified price Cthe stri!e priceD during a
specified period of time *or stoc! options, the amount is usually 100 shares )ach
option contract has a buyer, called the holder, and a seller, !nown as the writer If
the option contract is exercised, the writer is responsible for fulfilling the terms of
the contract *or the holder, the potential loss is limited to the price paid to ac#uire
the option When an option is not exercised, it expires 8o shares change hands and
the money spent to purchase the option is lost *or the buyer?holder, the upside is
unlimited *or the writer, the potential loss is unlimited and the profits are &ust
limited to the amount of option premium Iull C199GD has also tal!ed of call option
and put option
Web 1 opines H$ swap is a deri"ati"e product, where two counterparties
exchange one stream of cash flows against another stream %hese streams are
called the legs of the swap %he cash flows are calculated o"er a notional
principal amount %he notional amount typically does not change hands and it is
simply used to calculate payments 'waps are often used to hedge certain ris!s, for
instance interest rate ris! $nother use is speculationJ %here are two basic !inds
of swaps< Currency 'waps and Interest >ate 'waps
-$$) OF S".)1
%he study has been done to !now the different types of deri"ati"es and
also t o !now t he deri "at i "e mar!et i n Indi a %hi s st udy al so co"ers
t he recent de"elopments in the deri"ati"e mar!et ta!ing into account the
trading in past years %hrough this study I came to !now the trading done in
deri"ati"es and their use in the stoc! mar!ets
Ob2ectives of t#e Study
%he ob&ecti"es of the study are as follows<
%o ha"e an o"er"iew of Indian deri"ati"e mar!et
%o ha"e a loo! on the e"olution of "arious deri"ati"e products
%o find out the trading mechanism of different deri"ati"e products
%o examine the "arious issues in the Indian deri"ati"e mar!et and future
prospects of
this mar!et
SCO/$ OF "'$ /RO3$C"
%he pro& ect co"ers t he deri "at i "es mar !et and i t s i nst rument s *or
bet t er understanding "arious strategies with different situations and
actions ha"e been gi "en It i ncl udes t he dat a col l ect ed i n t he recent
years and al so t he mar!et in the deri"ati"es in the recent years %his study
extends to the trading of deri"ati"es done in the 8ational 'toc! (ar!ets
R$S$ARC' $"'O)O0O41
et#od of data collection:%
Secondary sources:%
I t i s t he da t a whi c h ha s a l r e a dy be e n c ol l e c t e d by s ome one
or a n organization for some other purpose or research study %he data for
study has been collected from "arious sources<
7oo!s
Fournals
(agazines
Internet sources
"ime: 0 months
Statistical "ools .sed: 'imple tools li!e bar graphs, tabulation, line diagrams ha"e
been used

0II"A"IO-S OF S".)1
10II"$) "I$:
%he time a"ailable to conduct the study was only 0 months It being a
wide topic had a limited time
00II"$) R$SO.RC$S:
:imited resources are a"ailable to collect the information about the commodity
trading
45O0A"A0I"1:
'hare mar!et is so much "olatile and it is difficult to forecast any thing about it
whether you trade through online or offline
AAS/$C"S CO5$RA4$: 'ome of the aspects may not be co"ered in my study
"ypes of )erivatives
%he most commonly used deri"ati"es contracts are forwards, futures and
options which we shall discuss in detail later Iere we ta!e a brief loo! at
"arious deri"ati"es contracts that ha"e come to be used
Forwards: $ forward contract is a customised contract between two entities,
where settlement ta!es place on a specific date in the future at todays pre+
agreed price
Futures: $ futures contract is an agreement between two parties to buy or
sell an asset at a certain time in the future at a certain price *utures contracts
are special types of forward contracts in the sense that the former are
standardised exchange+traded contracts
Options: -ptions are of two types , calls and puts Calls gi"e the buyer the
right but not the obligation to buy a gi"en #uantity of the underlying asset, at
a gi"en price on or before a gi"en future date Euts gi"e the buyer the right,
but not the obligation to sell a gi"en #uantity of the underlying asset at a
gi"en price on or before a gi"en date
+arrants: -ptions generally ha"e li"es of upto one year, the ma&ority of
options traded on options exchanges ha"ing maximum maturity of nine
months :onger+dated options are called warrants and are generally traded
o"er+the+counter
0$A/S: %he acronym :)$E' means :ong %erm )#uity $nticipation
'ecurities %hese are options ha"ing a maturity of upto three years
&as!ets: bas!et options are options on portfolios of underlying assets %he
underlying asset is usually a mo"ing a"erage or a bas!et of assets )#uity
index options are a form of bas!et options
Swaps: 'waps are pri"ate agreements between two parties to exchange cash
flows in the future according to a prearranged formula %hey can be regarded
as portfolios of forward contracts %he two commonly used swaps are<
U Interest rate swaps: %hese entail swapping only the interest related cash
flows between the parties in the same currency
U Currency Swaps: %hese entail swapping both principal and interest
between the parties, with the cash flows in one direction being in a different
currency than those in the opposite direction
Swaptions: 'waptions are options to buy or sell a swap that will become
operati"e at the expiry of the options %hus, swaptions is an option on a
forward swap >ather than ha"e calls and puts, the swaptions mar!et has
recei"er swaptions and payer swaptions $ recei"er swaption is an option to
recei"e fixed and pay floating $ payer swaption is an option to pay fixed
and recei"e floating
Forward Contract
$ forward contract is an agreement to buy or sell an asset on a specified date for a
specified price -ne of the parties to the contract assumes a long position and
agrees to buy the underlying asset on a certain specified future date for a certain
specified price %he other party assumes a short position and agrees to sell the asset
on the same date for the same price
-ther contract details li!e deli"ery date, price and #uantity are negotiated
bilaterally by the parties to the contract %he forward contracts are normally traded
outside the exchanges
%he salient features of forward contracts are<
U %hey are bilateral contracts and hence exposed to counter,party ris!
U )ach contract is custom designed, and hence is uni#ue in terms of contract size,
expiration date and the asset type and #uality
U %he contract price is generally not a"ailable in public domain
U -n the expiration date, the contract has to be settled by deli"ery of the asset
U If the party wishes to re"erse the contract, it has to compulsorily go to the same
counterparty, which often results in high prices being charged
Iowe"er, forward contracts in certain mar!ets ha"e become "ery standardised, as
in the case of foreign exchange, thereby reducing transaction costs and increasing
transactions "olume %his process of standardisation reaches its limit in the
organised futures mar!et *orward contracts are "ery useful in hedging and
speculation %he classic hedging application would be that of an exporter who
expects to recei"e payment in dollars three months later Ie is exposed to the ris!
of exchange rate fluctuations by using the currency forward mar!et to sell dollars
forward, he can loc! on to a rate today and reduce his uncertainty 'imilarly an
importer who is re#uired to ma!e a payment in dollars two months hence can
reduce his exposure to exchange rate fluctuations by buying dollars forward If a
speculator has information or analysis, which forecasts an upturn in a price, then he
can go long on the forward mar!et instead of the cash mar!et %he speculator
would go long on the forward, wait for the price to rise, and then ta!e a re"ersing
transaction to boo! profits 'peculators may well be re#uired to deposit a margin
upfront Iowe"er, this is generally a relati"ely small proportion of the "alue of the
assets underlying the forward contract %he use of forward mar!ets here supplies
le"erage to the speculator
*orward mar!ets world+wide are afflicted by se"eral problems<
1 :ac! of centralisation of trading,
0 Illi#uidity, and
4 Counterparty ris!
In the first two of these, the basic problem is that of too much flexibility and
generality %he forward mar!et is li!e a real estate mar!et in that any two
consenting adults can form contracts against each other %his often ma!es them
design terms of the deal which are "ery con"enient in that specific situation, but
ma!es the contracts non+tradable Counterparty ris! arises from the possibility of
default by any one party to the transaction When one of the two sides to the
transaction declares ban!ruptcy, the other suffers )"en when forward mar!ets
trade standardised contracts, and hence a"oid the problem of illi#uidity, still the
counterparty ris! remains a "ery serious issue
Futures
*utures mar!ets were designed to sol"e the problems that exist in forward mar!ets
$ futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price but unli!e forward contracts, the futures
contracts are standardised and exchange traded %o facilitate li#uidity in the futures
contracts, the exchange specifies certain standard features of the contract It is a
standardised contract with standard underlying instrument, a standard #uantity and
#uality of the underlying instrument that can be deli"ered, Cor which can be used
for reference purposes in settlementD and a standard timing of such settlement $
futures contract may be offset prior to maturity by entering into an e#ual and
opposite transaction (ore than 99/ of futures transactions are offset this way
%he standardised items in a futures contract are<
U Quantity of the underlying
U %he date and the month of deli"ery
U %he units of price #uotation and minimum price change
U :ocation of settlement
Futures terminolo,y
6 Spot price: %he price at which an asset trades in the spot mar!et
6 Futures price: %he price at which the futures contract trades in the futures
mar!et
6 Contract cycle: %he period o"er which a contract trades %he index futures
contracts on the 8') ha"e one month, two+month and three+month expiry cycles
which expire on the last %hursday of the month %hus a Fanuary expiration contract
expires on the last %hursday of Fanuary and a *ebruary expiration contract ceases
trading on the last %hursday of *ebruary -n the *riday following the last
%hursday, a new contract ha"ing a three+month expiry is introduced for trading
6 $*piry date: It is the date specified in the futures contract %his is the last day
on which the contract will be traded, at the end of which it will cease to exist
6 Contract si(e: %he amount of asset that has to be deli"ered under one contract
$lso called as lot size
6 &asis: In the context of financial futures, basis can be defined as the futures
price minus the spot price %here will be a different basis for each deli"ery month
for each contract In a normal mar!et, basis will be positi"e %his reflects that
futures prices normally exceed spot prices
6 Cost of carry: %he relationship between futures prices and spot prices can be
summarised in terms of what is !nown as the cost of carry %his measures the
storage cost plus the interest that is paid to finance the asset less the income earned
on the asset
6 Initial mar,in: %he amount that must be deposited in the margin account at the
time a futures contract is first entered into is !nown as initial margin
6 ar!in,%to%mar!et: In the futures mar!et, at the end of each trading day, the
margin account is ad&usted to reflect the in"estors gain or loss depending upon the
futures closing price %his is called mar!ing,to,mar!et
6 aintenance mar,in: %his is somewhat lower than the initial margin %his is
set to ensure that the balance in the margin account ne"er becomes negati"e If the
balance in the margin account falls below the maintenance margin, the in"estor
recei"es a margin call and is expected to top up the margin account to the initial
margin le"el before trading commences on the next day
Options
-ptions are fundamentally different from forward and futures contracts $n option
gi"es the holder of the option the right to do something %he holder does not ha"e
to exercise this right In contrast, in a forward or futures contract, the two parties
ha"e committed themsel"es to doing something Whereas it costs nothing Cexcept
margin re#uirementsD to enter into a futures contract, the purchase of an option
re#uires an upfront payment
Options terminolo,y
6 Inde* options: %hese options ha"e the index as the underlying :i!e index
futures contracts, index options contracts are also cash settled
6 Stoc! options: 'toc! options are options on indi"idual stoc!s -ptions currently
trade on o"er G00 stoc!s in the Knited 'tates $ contract gi"es the holder the right
to buy or sell shares at the specified price
6 &uyer of an option: %he buyer of an option is the one who by paying the option
premium buys the right but not the obligation to exercise his option on the
seller?writer
6 +riter of an option: %he writer of a call?put option is the one who recei"es the
option premium and is thereby obliged to sell?buy the asset if the buyer wishes to
exercise his option
%here are two basic types of options, call options and put options
6 Call option: $ call option gi"es the holder the right but not the obligation to buy
an asset by a certain date for a certain price
6 /ut option: $ put option gi"es the holder the right but not the obligation to sell
an asset by a certain date for a certain price
6 Option price: -ption price is the price which the option buyer pays to the option
seller It is also referred to as the option premium
6 $*piration date: %he date specified in the options contract is !nown as the
expiration date, the exercise date, the stri!e date or the maturity
6 Stri!e price: %he price specified in the options contract is !nown as the stri!e
price or the exercise price
6 American options: $merican options are options that can be exercised at any
time upto the expiration date
6 $uropean options: )uropean options are options that can be exercised only on
the expiration date itself )uropean options are easier to analyse than $merican
options, and properties of an $merican option are fre#uently deduced from those of
its )uropean counterpart
6 In%t#e%money option: $n in+the+money CI%(D option is an option that would
lead to a positi"e cash flow to the holder if it were exercised immediately $ call
option on the index is said to be in+the+money when the current "alue of index
stands at a le"el higher than the stri!e price Cie spot price V stri!e priceD If the
"alue of index is much higher than the stri!e price, the call is said to be deep I%(
-n the other hand, a put option on index is said to be I%( if the "alue of index is
below the stri!e price
6 At%t#e%money option: $n at+the+money C$%(D option is an option that would
lead to zero cash flow if it were exercised immediately $n option on the index is
at+the+money when the "alue of current index e#uals the stri!e price Cie spot price
W stri!e priceD
6 Out%of%t#e%money option: $n out+of+the+money C-%(D option is an option that
would lead to a negati"e cash flow it was exercised immediately $ call option on
the index is said to be out+of+the+money when the "alue of current index stands at a
le"el which is less than the stri!e price Cie spot price X stri!e priceD If the index is
much lower than the stri!e price, the call is said to be deep -%( -n the other
hand, a put option on index is -%( if the "alue of index is abo"e the stri!e price
6 Intrinsic value of an option: %he option premium can be bro!en down into two
components,intrinsic "alue and time "alue Intrinsic "alue of an option is the
difference between the mar!et "alue of the underlying security?index in a traded
option and the stri!e price %he intrinsic "alue of a call is the amount when the
option is I%(, if it is I%( If the call is -%(, its intrinsic "alue is zero
6 "ime value of an option: %he time "alue of an option is the difference between
its premium and its intrinsic "alue both calls and puts ha"e time "alue $n option
that is -%( or $%( has only time "alue Ksually, the maximum time "alue exists
when the option is $%( %he longer the time to expiration, the greater is an
options time "alue, all else e#ual $t expiration, an option should ha"e no time
"alue While intrinsic "alue is easy to calculate, time "alue is more difficult to
calculate Iistorically, this made it difficult to "alue options prior to their
expiration Oarious option pricing methodologies were proposed, but the problem
wasnt sol"ed until the emergence of blac!+'choles theory in 1934
S+A/S %
'wa ps a r e t r a ns a c t i ons whi c h obl i ga t e s t he t wo pa r t i e s
t o t he c ont r a c t t o exchange a ser i es of cash fl ows at
speci fi ed i nt er "al s !nown as payment or settlement dates %hey
can be regarded as portfolios of forward6s contracts $ cont r act
whereby t wo par t i es agr ee t o exchange C swapD payment s,
based on some notional principle amount is called as a P'W$E In
case of swap, only the payment flows are exchanged and not the
principle amount %he two commonly used swaps are<
I-"$R$S" RA"$ S+A/S:
Interest rate swaps is an arrangement by which one party agrees to
exchange his series of fixed rate interest payments to a party in
exchange for his "ariable rate interest payments %he fixed rate payer
ta!es a short position in the forward cont r act whereas t he fl oat i ng
r at e payer t a!es a l ong posi t i on i n t he for ward contract
C.RR$-C1 S+A/S:
Currency swaps is an arrangement in which both the principle
amount and the interest on loan in one currency are swapped for the
principle and the interest pa y me nt s on l oa n i n a not he r
c ur r e nc y %he pa r t i e s t o t he s wa p c ont r a c t of currency
generally hail from two different countries %his arrangement allows the
counter parties to borrow easily and cheaply in their home
currencies Knder a currency swap, cash flows to be exchanged are
determined at the spot rate at a time when swap is done 'uch cash flows
are supposed to remain unaffected by subse#uent changes in the exchange
rates
FI-A-CIA0 S+A/:
*i nanci al swaps const i t ut e a fundi ng t echni #ue whi ch per mi t a
borrower t o access one mar!et and then exchange the liability for
another type of liability It also allows the in"estors to exchange one type
of asset for another type of asset with a preferred income stream
&AS7$"S %
7as!ets options are option on portfolio of underlying asset )#uity Index
-ptions are most popular form of bas!ets
0$A/S %
8ormally option contracts are for a period of 1 to 10 months
Iowe"er, exchange may i nt roduce opt i on cont r act s wi t h a
mat uri t y peri od of 0+4 years %hese long+term option contracts
are popularly !nown as :eaps or :ong term )#uity $nticipation
'ecurities
+ARRA-"S %
-ptions generally ha"e li"es of up to one year, the ma&ority of
options traded on options exchanges ha"ing a maximum maturity of
nine months :onger+dated options are called warrants and are generally
traded o"er+the+counter
S+A/"IO-S %
'wapt i ons ar e opt i ons t o buy or sel l a swap t hat wi l l become
operat i "e at t he expiry of the options %hus a swaption is an
option on a forward swap >ather than ha"e calls and puts, the swaptions
mar!et has recei"er swaptions and payer swaptions $ recei"er swaption
is an option to recei"e fixed and pay floating $ payer swaption is an
option to pay fixed and recei"e floating
)evelopment of )erivatives ar!ets in India
Indian 5eri"ati"es mar!ets ha"e been in existence in one form or the other for a
long time In the area of commodities, the 7ombay Cotton %rade $ssociation
started futures trading in 1.3G In 19G0, with the ban on cash settlement and option
trading by the @o"ernment of India, deri"ati"es trading shifted to informal
forwards mar!ets In recent years, go"ernment policy has shifted in fa"or of an
increased role of mar!et+based pricing and less suspicious deri"ati"es trading %he
first step towards the introduction of financial deri"ati"es trading in India was the
promulgation of the 'ecurities :aws C$mendmentD -rdinance, 199G %his pro"ided
for withdrawal of prohibition on options in securities In the last decade, beginning
the year 0000, ban on futures trading in many commodities was lifted out 5uring
the same period, 8ational )lectronic Commodity )xchanges were also set up
5eri"ati"es trading commenced in India in Fune 0000 after ')7I granted the final
appro"al to this effect in (ay 0001 on the recommendation of : C @upta
committee 'ecurities and )xchange 7oard of India C')7ID permitted the
deri"ati"e segments of two stoc! exchanges, 8') and 7'), and their clearing
house?corporation to commence trading and settlement in appro"ed deri"ati"es
contracts Initially ')7I appro"ed trading in index futures contracts based on
"arious stoc! mar!et indices such as, 'YE C8Z, 8ifty and 'ensex 'ubse#uently,
index+based trading was permitted in options as well as indi"idual securities
)erivatives /roducts "raded in )erivatives Se,ment of &S$
%he 7ombay 'toc! )xchange C7')D created history on Fune 9, 0000 when it
launched trading in 'ensex based futures contract for the first time It was then
followed by trading in index options on Fune 1, 0001B in stoc! options and single
stoc! futures C41 stoc!sD on Fuly 9, 0001 and 8o"ember 9, 0000, respecti"ely It
permitted trading in the stoc!s of four leading companies namelyB 'atyam, 'tate
7an! of India, >eliance Industries and %I'C- Crenamed now %ata 'teelD Chhota
CminiD ')8')Z3 was launched on Fanuary 1, 000. With a small or 6mini6 mar!et
lot of G, it allows for comparati"ely lower capital outlay, lower trading costs, more
precise hedging and flexible trading Currency futures were introduced on -ctober
1, 000. to enable participants to hedge their currency ris!s through trading in the
K' dollar+rupee future platforms %able 1 summarily specifies the deri"ati"e
products and their date of introduction on the 7')
)erivatives /roducts "raded in )erivatives Se,ment of -S$
8') started trading in index futures, based on popular 'YE C8Z Index, on Fune
10, 0000 as its first deri"ati"es product %rading in index options was introduced
on Fune A, 0001 -n 8o"ember 9, 0001, *utures on indi"idual securities started $s
stated by the 'ecurities Y )xchange 7oard of India C')7ID, futures contracts are
a"ailable on 044 securities %rading in options on indi"idual securities commenced
wef Fuly 0, 0001 %he options contracts, a"ailable on 044 securities, are of
$merican style and cash settled %rading in interest rate futures was started on 0A
Fune 0004 but it was closed subse#uently due to pricing problem %he 8')
achie"ed another landmar! in product introduction by launching (ini Index
*utures Y -ptions with a minimum contract size of >s 1 lac 8') created history
by launching currency futures contract on K' 5ollar+>upee on $ugust 09, 000. in
Indian 5eri"ati"es mar!et %able 0 presents a description of the types of products
traded at *Y - segment of 8')
"RA)I-4 S1S"$
Introduction
%he futures Y options trading system of 8'), called P8ational )xchange for
$utomated %rading 8)$%+*Y- trading system, pro"ides a fully automated
screen+based trading for Index futures Y options, stoc! futures Y options and
futures on interest rate on a nationwide basis as well as an online monitoring and
sur"eillance mechanism It supports an order dri"en mar!et and pro"ides complete
transparency of trading operations It is similar to that of trading of e#uities in the
cash mar!et segment %he software for the *Y- mar!et has been de"eloped to
facilitate efficient and transparent trading in futures and options instruments
Leeping in "iew the familiarity of trading members with the current capital mar!et
trading system, modifications ha"e been performed in the existing capital mar!et
trading system so as to ma!e it suitable for trading futures and options
"radin, mec#anism
%he 8)$% *Y- system supports an order dri"en mar!et, wherein orders match
automatically -rder matching is essentially on the basis of security, its price, time
and #uantity $ll #uantity fields are in units and price in rupees %he lot size on the
futures and options mar!et is G0 for 8ifty %he exchange notifies the regular lot
size and tic! size for each security traded on this segment from time to time
-rders, as and when they are recei"ed, are first time stamped and then immediately
processed for potential match When any order enters the trading system, it is an
acti"e order If it finds a match, a trade is generated If a match is not found, then
the orders are stored in different Pboo!s -rders are stored in price+time priority in
"arious boo!s in the following se#uence<
U 7est Erice
U Within Erice, by time priority
%here are four entities in the trading system of a deri"ati"e mar!et<
89 "radin, members: %rading members can trade either on their own account or
on behalf of their clients including participants %hey are registered as members
with 8') and are assigned an exclusi"e trading member I5
:9 Clearin, members: Clearing members are members of 8'CC: %hey carry
out confirmation?in#uiry of trades and the ris! management acti"ities through the
trading system %hese clearing members are also trading members and clear trade
for themsel"es or?and other
;9 /rofessional clearin, members: $ clearing member who is not a trading
member is !nown a professional clearing member CEC(D %ypically, ban!s and
custodian become EC(s and clear and settle for their trading members
<9 /articipants: $ participant is a client of trading members li!e financial
institutions %hese clients may trade through multiple trading members, but settle
their trades through a single clearing member only %he terminals of trading of
futures Y options segment are a"ailable in 09. cities at the end of (arch 0001
7esides trading terminals, it can also be accessed through the internet by in"estors
from anywhere
"rade )etails of )erivatives ar!et
$fter recording a 10A4 percent growth C0009,0010D in trading "olume on year+on+
year basis, the 8')s deri"ati"es mar!et continued its momentum in 0010,0011 by
ha"ing a growth rate of 1GG. percent C%able 4D %he 8') further strengthened its
dominance in the deri"ati"es segment in 0010,0011 by ha"ing a share of 9999
percent of the total turno"er in this segment %he share of the 7') in the total
deri"ati"es mar!et turno"er fell from 00014 percent in 0009,0010 to 0000G
percent in 0010,0011 %he total turno"er of the deri"ati"es segment increased by
01G1 percent during the first half of 0011,0010 compared to the turno"er in the
corresponding period in the pre"ious fiscal year In terms of product wise turno"er
of futures and options segment in the 8'), index options segment was the clear
leader in 0010,0011 C*igure IIID
Fi,ure I: "rade )etails of )erivatives in -S$

Fi,ure II: "rade details of )erivatives in &S$

Fi,ure III: /roduct%wise distribution of turnover of F=O se,ment of -S$
>:?8?%88@

.nresolved Issues and Future /rospects
)"en though the deri"ati"es mar!et has shown good progress in the last few years,
the real issues facing the future of the mar!et ha"e not yet been resol"ed %he
number of products allowed for deri"ati"e trading ha"e increased and the "olume
and the "alue of business has zoomed, but the ob&ecti"es of setting up different
deri"ati"e exchanges may not be achie"ed and the growth rates witnessed may not
be sustainable unless these real issues are sorted out as soon as possible 'ome of
the main unresol"ed issues are as under
Commodity Options: %rading in commodity options contracts has been stopped
since 19G0 %he mar!et for commodity deri"ati"es is not completed without the
presence of this important deri"ati"e 7oth futures and options are necessary for
the healthy growth of the mar!et %here is an immediate need to bring about the
necessary legal and regulatory changes to introduce commodity options trading in
the country %he matter is belie"ed to be under the acti"e consideration of the
@o"ernment and the options trading may be introduced in the near future
Issues for ar!et Stability and )evelopment: %he enormous size and fast
growth of the -"er the Counter C-%CD deri"ati"es mar!et has attracted the
attention of regulators and super"isory bodies 'ome -%C deri"ati"es ha"e been
"iewed as amplifiers of the stress in the present global financial crisis %he more
common criticisms relate to the fact that the -%C mar!ets are less transparent and
highly le"eraged, ha"e wea!er capital re#uirements and contain elements of hidden
systemic ris!
"#e +are#ousin, and Standardi(ation: *or commodity deri"ati"es mar!et to
wor! smoothly, it is necessary to ha"e a sophisticated, cost+effecti"e, reliable and
con"enient warehousing system in the country %he Iabibullah C0004D tas! force
admitted, H$ sophisticated warehousing industry has yet to come aboutJ *urther,
independent labs or #uality testing centers should be set up in each region to certify
the #uality, grade and #uantity of commodities so that they are appropriately
standardized and there are no shoc!s waiting for the ultimate buyer who ta!es the
physical deli"ery
Cas# vs9 /#ysical Settlement: -nly about 1/ to G/ of the total commodity
deri"ati"es trade in the country is settled in physical deli"ery It is probably due to
the inefficiencies in the present warehousing system %herefore the warehousing
problem ob"iously has to be handled on a war footing, as a good deli"ery system
is the bac!bone of any commodity trade $ ma&or problem in cash settlement of
commodity deri"ati"e contracts is that at present, under the *orward Contracts
C>egulationD $ct 19G0, cash settlement of outstanding contracts at maturity is
disallowed In other words, all outstanding contracts at maturity should be settled
in physical deli"ery %o a"oid this, participants settle their positions before
maturity 'o, in practice, most contracts are settled in cash but before maturity
%here is a need to modify the law to bring it closer to the widespread practice and
sa"e the participants from unnecessary hassles
Increased Off%&alance S#eet $*posure of Indian &an!s: %he growth of
deri"ati"es as off+balance sheet C-7'D items of Indian 7an!s has been an area of
concern for the >7I %he -7' exposure?ris! has increased significantly in recent
years %he notional principal amount of -7' exposure increased from >s.,A0,000
crore at the end of (arch 0000 Capproximately 21.1 billion at the exchange rate of
>sA11 to a K' 2D to >s1A9,19,000 crore Capproximately 2401 billionD at the end
of (arch 000. C>7I, 0009D
"#e Re,ulator: $s the mar!et acti"ity pic!+up and the "olumes rise, the mar!et
will definitely need a strong and independent regulatorB similar to the 'ecurities
and )xchange 7oard of India C')7ID that regulates the securities mar!ets Knli!e
')7I which is an independent body, the *orwards (ar!ets Commission C*(CD is
under the 5epartment of Consumer $ffairs C(inistry of Consumer $ffairs, *ood
and Eublic 5istributionD and depends on it for funds It is imperati"e that the
@o"ernment should grant more powers to the *(C to ensure an orderly
de"elopment of the commodity mar!ets %he ')7I and *(C also need to wor!
closely with each other due to the inter+relationship between the two mar!ets
Competition of O"C derivatives wit# t#e $*c#an,e%traded
)erivatives: $ general "iew emerging after the recent financial crisis is that -%C
deri"ati"es trading should be mo"ed to an exchange platform %he proponents of
this "iew hope that this would increase li#uidity and reduce significantly the
opacity of the mar!et %hey argue that exchanges pro"ide transparent and reliable
price formation mechanisms, neutrality, robust and appropriate technology, better
regulation and, abo"e all, centralized clearing and settlement system %hese
arguments are based on the assumption that the existing method of trading in -%C
products is all based on telephone trading and there is no clearing system in place
0ac! of $conomies of Scale: %here are too many C4 national le"el and 01
regionalD commodity exchanges %hough o"er .0 commodities are allowed for
deri"ati"es trading, in practice deri"ati"es are popular for only a few commodities
$gain, most of the trade ta!es place only on a few exchanges $ll this splits
"olumes and ma!es some exchanges un"iable %his problem can possibly be
addressed by consolidating some exchanges $lso, the #uestion of con"ergence of
securities and commodities deri"ati"es mar!ets has been debated for a long time
now %he @o"ernment of India has announced its intention to integrate the two
mar!ets It is felt that con"ergence of these deri"ati"e mar!ets would bring in
economies of scale and scope without ha"ing to duplicate the efforts, thereby
gi"ing a boost to the growth of commodity deri"ati"es mar!et It would also help
in resol"ing some of the issues concerning regulation of the deri"ati"e mar!ets
Iowe"er, this would necessitate complete coordination among "arious regulating
authorities such as >eser"e 7an! of India, *orward (ar!ets commission, the
'ecurities and )xchange 7oard of India, and the 5epartment of Company affairs
etc
Stren,t#enin, t#e Centrali(ed Clearin, /arties: CCI:, which started
functioning in 0000, is the only centralized clearing party for trade processing and
settlement ser"ices in India It currently pro"ides a guaranteed settlement facility
for go"ernment securities trading, clearing of collateralized borrowing and lending
obligations CC7:-D, guaranteed settlement of foreign exchange trading, and
settlement of all Indian >e"enue 'er"ice CI>'D %hough the concentration of
business relating to money, securities and forex mar!ets with the CCI: helps in
pooling ris!s and reducing the o"erall transactions costs for the system, the
Certified *inancial 'er"ices $uditors CC*'$D report opined that the concentration
of such a wide spectrum of acti"ities leads to concentration of ris!s in one entity
%herefore, there is the need to strengthen more and more clearing parties
"a* and 0e,al bottlenec!s: In India, at present there are tax restrictions on the
mo"ement of certain goods from one state to another %hese need to be remo"ed so
that a truly national mar!et could de"elop for commodities and deri"ati"es $lso,
regulatory changes are re#uired to bring about uniformity in octroi and sales taxes
etc O$% has been introduced in the country in 000G, but has not yet been
uniformly implemented by all states
-ew )erivatives /roducts for Credit Ris! "ransfer >CR"@: Credit ris!
transfer CC>%D, in a broad sense Cincluding guarantees, loan syndication, and
securitizationD,has a long history Iowe"er, there has been a sustained and rapid
growth of new and inno"ati"e forms of C>% associated with credit deri"ati"es %he
most common credit deri"ati"es are credit default swaps CC5'D on single
corporate entity Csingle+name C5'D and collateralized debt obligations CC5-sD
'ince 000G, C>% acti"ity became significant for two additional underlying asset
classes , asset bac!ed securities C$7'D and le"eraged loans Internationally, ban!s
and financial institutions are able to protect themsel"es from credit default ris!
through the mechanism of credit deri"ati"es Iowe"er, credit deri"ati"es were not
allowed in India until recently %he >7I has made an announcement in its second+
#uarter monetary policy 0009+10 that it has considered it appropriate to proceed
with caution on this issue %o start with Ist 5ecember 0011, >7I has introduced
guidelines for a basic, o"er+the+counter, single name C5' for corporate bonds for
resident entities, sub&ect to safeguards
R$CO$-)A"IO-S A-) S.4$S"IO-S
>7I should play a greater role in supporting deri"ati"es
5er i "at i "es mar!et shoul d be de"el oped i n or der t o !eep i t at
par wi t h other deri"ati"e mar!ets in the world
'peculation should be discouraged
%here must be more deri"ati"e instruments aimed at indi"idual in"estors
')7I should conduct seminars regarding the use of deri"ati"es to educate
indi"idual in"estors
$fter study it is clear that 5eri"ati"e influence our Indian )conomy
upt o m u c h e x t e n t ' o , ' ) 7 I s h o u l d t a ! e
n e c e s s a r y s t e p s f o r impro"ement in 5eri"ati"e (ar!et so that
more in"estors can in"est in 5eri"ati"e mar!et
%here is a need of more inno"ation in 5eri"ati"e (ar!et because in
t oda y s c e na r i o e "e n e duc a t e d pe opl e a l s o f e a r f or
i n"e s t i ng i n 5eri"ati"e (ar!et 7ecause of high ris! in"ol"ed in
5eri"ati"es
Conclusion: %he Indian deri"ati"e mar!et has achie"ed tremendous growth
o"er the years, and also has a long history of trading in "arious deri"ati"es
products %he deri"ati"es mar!et has seen ups and downs %he new and
inno"ati"e deri"ati"e products ha"e emerged o"er the time to meet the
"arious needs of the different types of in"estors %hough, the deri"ati"e
mar!et is burgeoning with its di"ergent products, yet there are many issues
$mong the issues that need to be immediately addressed are those related to,
lac! of economies of scale, tax and legal bottlenec!s, increased off+balance
sheet exposure of Indian ban!s, need for an independent regulator etc
'olution of these issues will definitely lead to boost the in"estors
confidence in the Indian deri"ati"e mar!et and bring an o"erall de"elopment
in all the segments of this mar!et